An Empirical Test of the Pricing of VPO Contracts
Source TitleAustralian Journal of Management
University of Melbourne Author/sHandley, John
Document TypeJournal Article
CitationsHandley, J. C. (2003). An Empirical Test of the Pricing of VPO Contracts. Australian Journal of Management, 28 (1), pp.1-21. https://doi.org/10.1177/031289620302800101.
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C1 - Refereed Journal Article
A variable purchase option (VPO) is a call option issued by a company on a stochastic rather than on a fixed number of its ordinary shares. This paper tests the arbitrage-free pricing model of Handley (2000) using a transactions dataset of actual market prices covering the five VPOs traded on the Australian Stock Exchange during the six-year period from May 1992 to May 1998. It is initially found that the model systematically overprices VPOs. A subsequent case-based explanatory analysis of the pricing errors, however, shows that this mispricing substantially disappears under different estimates of two key parameters. The results are consistent with investors using risk-adjusted discount rates rather than the risk-free rate in valuing the bond component of the VPO and, when material, using a narrow range of volatility estimates, rather than historic volatility estimates, in valuing the option component of the VPO.
KeywordsBanking; Finance and Investment
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